Volume 60 | Number 8
I am going to write something positive about the economy. I give fair warning so those that think I am an eternal pessimist will not be shocked. It will not be wildly optimistic, but it appears to me that theUS economy is near the end of its recent troubles – not at the beginning of a new crisis. This is not a view that is universally shared within McVean trading, so the purpose of this letter is to explain my reasoning.
First and foremost, my view of the world is that events are not linear, but cyclical. Trees don’t grow to the sky and you can’t dig a hole to China. Along the way, prices and policies change that stall the linear movement and eventually reverse it. I believe that the recent angst about a double dip recession has reached the point that both prices and policies are changing to bend the curve. Long term interest rates have declined sharply from 3.73% on the ten year note in the spring to just under 2.0% as we write. The Federal Reserve is apparently considering new stimulative action in the form of an Operation Twist, where it may swap $60 billion a month in short term debt for longer term securities. The President will make new (I use the word loosely) proposals to stimulate job growth in a speech before the joint session of Congress on September 8nd. (Unless it is broadcast on the big screen at Lambeau Field, I will miss it. Thanks Bart.) There is some indication that the GSEs (Fannie Mae and Freddie Mac) may loosen the requirements on loan to value ratios for homeowners refinancing loans held in their portfolios. There is also talk that they may shift some foreclosures (they own one-third of all foreclosed homes) to the rental market. In Europe, we are likely to gain some clarity on the bailout procedure as the German courts will rule on whether or not the current process is legal on September 7th. Bottom line, the recent weakness has been painful enough that both the visible and the invisible hands are working to ease the pain. Usually, when the weak hands are screaming the loudest, the strong hands finally act to take advantage of the situation.
We do not predict that these price and policy changes will lead to a robust expansion. Rather a continued muddle-through remains the most likely scenario. We do not expect a double dip recession, primarily because we believe it is more likely that we are at the end of a recession than at the beginning. After two quarters of sub-1% growth in the first half, the third quarter is likely to pass that low bar only due to the auto rebound. However, when all of the annual revisions are in a few years down the road, we would not be surprised to find that real economic growth was slightly negative in the first half of 2011 – especially from downward revisions in the service sector and small business start ups.
The key to our somewhat more positive outlook is in understanding that the private sector has preformed far better in 2011 than the aggregate data on both employment and GDP. Private sector hiring over the past two months averaged 87,000 – or 110,000 after adjusting for the Verizon strike. This is a modest improvement from the 87,000 average in May and June. Meanwhile, government jobs fell -44,000 over the past two months, just slightly better than the average -50,000 decline in May and June. Moreover, the vast bulk of this month’s downward revisions to the past two month’s data (-50,000 of -58,000) were in local education. In the eight months since the start of the year, private sector hiring has averaged 145,000 a month – almost exactly the average 143,000 increase in the expansion from January 2004 to December 2007. Meanwhile, government employment has fallen an average -36,000 a month, a whopping -53,000 less than the tepid +17,000 average monthly growth during the past expansion.
Government spending has been a significant drag on real GDP over the past three quarters, declining at an average -3.2% annual rate. In the first half of 2011, private sector GDP rose 1.7% — clearly not a barn burner, but far from recession. Overall real GDP rose at a far more anemic 0.7% annual rate, due to the drag from government. However, a reduction in government spending was precisely the correction of excesses that was needed in 2011. In 2008, the recession was a correction of far too much new construction – and after three brutal quarters averaging -28.7% annualized declines in total construction spending, a shift to merely painful -14.0% annualized declines in the next three quarters was a positive contributor to the recovery in 2009. Bottom line, if the 20% of the economy represented by government only improves to a less pronounced rate of decline it will still be a boost to overall growth that could generate a positive multiplier effect in the private sector.
A second key observation on why we don’t see a double dip recession is the lack of a credit cycle in this economic expansion. Typical post-war recoveries were marked by strong up trends in credit spending after a Federal Reserve engineered decline in borrowing costs. The availability of cheaper credit sparked consumers to purchase leveraged assets, like houses, cars, and other durables. The surge in buying – particularly in housing – spurred businesses top line, which encouraged them to hire and invest in new capacity. These new jobs added to the upward spiral in credit driven purchases, and the virtuous cycle became self-fulfilling. In this cycle, consumers are still paying down debt and we have seen little effect from lower interest rates on housing or autos. The decline in interest rates has benefitted businesses, as they are able to roll over loans at far lower interest rates. However, this improvement in profitability is not associated with top line growth, so there is no need to hire in response to the improvement in margins. Without hiring and a credit response generated by that hiring, the cycle has a much slower initial growth dynamic than in traditional post-war cycles.
Despite strong stimulus in 2009, the economy was not able to achieve the normal terminal velocity and it is now falling back to Earth as the previously positive aspects of stimulus unwind. We agree that the potential for a $120 billion tax hike on January 1st when the FICA payroll holiday ends is a significant risk to the expansion. It would trim -0.8% off of real GDP in 2012 – or -3.2% in the first quarter alone. However, if the government sector improves from a -3.2% annualized rate of decline to merely flat, that would provide an offsetting 0.6% improvement in GDP growth for 2012 – and perhaps at the same time the payroll tax is ending. It appears from the jobs data that the third quarter will still be tough for the government sector, so improvement is unlikely before the fourth quarter and into 2012. Moreover, the tough love of narrowing the budget deficit in early 2012 may be seen by the financial markets as a positive, generating a wealth effect that helps lift spending. Again, we do not see a path to robust growth any time soon – but it appears that an improvement from dismal to merely lackluster performance in the large government sector could provide a better underpinning for growth than currently seen by the consensus.
Why Wasn’t it Worse?
It has hardly been a secret that July and August were soft months for the economy. The widely expected auto pop in early July, when plants that were normally shut down were supposed to operate flat out, was a bust. In early August, the debt ceiling debate and subsequent downgrade of the US debt rating paralyzed businesses, led to a sharp sell-off in equity markets, 2% ten year notes, and exceptionally low consumer and CEO confidence readings. Yet, as noted above, average hiring in the private sector has been better over the past two months than in May and June. True, hiring ex-Verizon was only 62,000 in August, but that come after a robust 156,000 new private sector jobs in July. Why didn’t firms cut back harder?
Our interpretation is that as bad as the financial markets may have looked, the weakness in private sector’s real economy is not so clear cut. Indeed, while there have been some horribly soft readings like the Philadelphia Fed (taken right at the time of maximum concern about debt and downgrades), there have been unexpectedly strong readings like industrial production. We like to focus on the preponderance of the evidence. As we see it, the economy was strong in February, March and April, with robust readings in ISM and employment, which helped push ten year notes and oil to their highs early in the year. Then, the Japanese earthquake on March 11th threw a wrench into the expansion. At first, firms were slow to react as it took a while for supply chain pipelines to empty out. At the same time, the lagged effects of higher interest rates and higher gasoline prices began to work on housing and consumers. By May, the ISM was sagging – especially for new orders – and employment was beginning to correct. However, while supply chain problems slowed real GDP, it remained positive and ISM never broke 50 – remaining well above the 42.5 level, which has signaled past recessions. Of particular interest in the employment sector, initial claims for unemployment were rising between March 12th and May 21st, but have declined since then averaging about 410,000 over the past eight weeks – with some upward Verizon distortion in the most recent data. Firms may not be hiring aggressively, but they are not laying off either. Interestingly, two other employment indicators – ADP and the household survey’s private sector wage and salary workers (excluding household workers) – both show exactly the same pattern as the payroll data, with strong hiring in the 200,000 range in February, March and April, then weaker hiring over the past four months, but with more strength in July and August than in May and June. Like I said, we like preponderance of the evidence.
Finally, despite the weakness in consumer confidence and despite the apparent slowdown in hiring, the consumer continues to spend at a decent pace. In July, consumer spending rose a robust 0.8%, coming off a weak-0.1% in June. For August, same store sales at retail chains were up 4.6% from a year ago, the same as in July. Similarly, new vehicle sales were at a 12.1 million unit pace in August, down fractionally from the 12.2 million selling rate in July — and at the average of the second quarter. While there is no acceleration in any of this data, we find no signs of a recession either — just more muddling along. Indeed, given the lack of credit driven purchases in the consumer sector, the key threat to future spending must be from swings in income. It will remain tough for those who are unemployed and for those facing layoffs in the government sector, but job growth in the private sector should remain solid. We expect an ebbing of the education layoffs after September will provide a better tone to overall employment by the end of the year, relieving the markets of some of its concern about a double dip recession.
However, we remain concerned that the new potential growth rate for theUSeconomy is in the low 2% range, well below even the reduced expectations of the Federal Reserve and government budget estimates. A lack of investment since 2008 has erodedUSproductive capacity. As a result, low growth in GDP and employment, low inflation, low productivity and further low investment all seem in the future for some time. This will keep the financial markets on a knife’s edge since any instability – at home or abroad – could tip sentiment back toward recession. As Will Roger’s noted, it is more about return of assets than return on assets. Indeed, risk of recession and deflation is central to the hoarding of cash by corporations, which limits investment and the potential for an upside breakout in growth. Perhaps the election will redraw the economic outlook, but that fork in the road is still fourteen months away – a lifetime for peripatetic financial market traders.